Washington Budget Battles Have a New Twist for Wall Street

Are debt ceiling, budget issues a stealth headline risk?

When it comes to fiscal debates in Washington, investors have become used to the playbook. Worries about the failure to reach a compromise lead to a stock market downturn in the weeks leading up to the relevant deadline, but eventually politicians save the day — and the markets — with an eleventh-hour deal.

The next set of deadlines is now approaching, but investors aren’t waiting around for the familiar storyline to play out before hitting the “buy” button. Instead, they’re ignoring the coming battles in Washington almost entirely, as evidenced by the nearly 4% rally in the S&P 500 in the past 12 sessions.

But is it wise to completely write off the potential for event risk in the coming weeks?

Two Key Events on Tap

Two potential issues could affect market performance between now and mid-October. First, Congress needs to pass a continuing budget resolution to fund the government past Sept. 30 or risk the chance of a government “shutdown.” As of yet, this remains an open issue largely due to the lack of an agreement the conservative wing of the Republican party, which wants any agreement to include a defunding of the Affordable Care Act (or “Obamacare”), and centrist Republicans, who are willing to compromise with Democrats.

The second issue is the debt ceiling. Currently, the Treasury has reached the debt limit and cannot issue new debt without congressional authorization. The Treasury is currently funding the government with stop-gap measures, but Secretary Jacob Lew estimates that these measures will be exhausted by mid-October. This sets up the possibility (however remote) of a debt default if no compromise is reached.

If this story sounds familiar, that’s because it is. Recall that in July-August 2011, concerns that the U.S. government would default on its debt led to a downgrade from Standard & Poor’s and sparked a 16% decline in the stock market in just nine sessions. Policymakers reached a compromise at the last minute, and stocks — after bouncing sideways for two months — eventually recovered. Six months later, the S&P 500 stood 22% above its August low.

The tumult surrounding the “fiscal cliff” brought a similar result at the end of 2012. Worries that politicians would allow the combination of spending cuts and tax increases to go. After the agreement was reached — just hours before the Jan. 1 midnight deadline — the market powered to a 10.5% first-quarter gain.

What Happens This Time?

Is there anything to worry about right now? Most likely, no. The core issues are the same now as they were in both 2011 and 2012, and the government remains divided into what’s slowly evolving into a three-party system: Democrats, mainstream Republicans, and conservatives. These hurdles didn’t prevent a last-minute compromise in the past, and it’s unlikely any of these groups will be willing to take the country over a cliff in the name of principal this time.

As a result, the continued gains in stocks — despite looming event risk — indicates that investors are saying, “Fool me twice, shame on me.”

However, this sets up a different risk-reward equation than what was in place in either 2011 or 2012. Whereas in the last two cases of political uncertainty, the markets fell heading into the deadline — thereby setting up the chance for a positive surprise — now the markets are rising as the deadlines approach. This sets up the opposite scenario: the chance that a negative surprise will move the markets.

This is underscored by the low level of the CBOE Volatility Index (VIX), which has retreated into the 14s despite the rising headline risk.

What should investors do about this? While there’s certainly no cause for panic, the unfavorable risk-reward equation does indicate that this might be a prime time to lock in gains or add protection on the cheap. It also might pay to act quickly, since the the “tapering” issue will be resolved — at least temporarily — after the Fed meeting tomorrow afternoon.

With this issue out of the way, investors might begin to take a closer look at the fiscal battles taking place on the other side of the nation’s capital.

It’s said that nobody ever went broke taking profits — an old adage that makes even more sense when political shenanigans are on the horizon.

The opinions contained in this column are solely those of the writer.

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